US and Foreign Markets Continue to Grow, but Volatility May Increase

Markets across the globe performed well through the third quarter of 2017 as volatility remains historically low. Congressional and geopolitical issues continue to create the potential for increased uncertainty in investors’ minds, but the market has yet to respond negatively.

Market Summary

Globally, most asset classes posted positive returns in the third quarter. We continue to see strong returns and good opportunity in European and emerging market equities. Valuations in these markets remain attractive when compared to domestic equities, and demographics in the emerging markets offer compelling potential for long-term growth.

On the fixed income side, the Federal Reserve declined to raise rates in September but their future actions may create uncertainty in the market. Outside of traditional bonds, bank loans, alternative lending, and high-yield bonds are providing compelling yields while offering investors the opportunity to diversify their portfolios.

Top Factors Impacting Markets

While current economic data points toward sustained domestic and global economic growth, market volatility may increase because of other influencing factors.  

Global Growth Acceleration

The majority of economies across the globe are expanding, and most developed economies are in the mid-to-late stage of their business cycle. Global growth hasn’t been this synchronized since 2010. This growth provides a positive backdrop for the markets since many large corporations derive portions of their revenues from outside their home country.

Reduction of the Fed’s Balance Sheet

On Wednesday, September 20, 2017, the Federal Reserve announced it would begin the process of scaling back its $4.5 trillion balance sheet. To do so, the Fed will slowly stop reinvesting into its debt portfolio—a sign that it would like to start managing its debt levels and believes the US economy can handle the increased bond supply and decreased money supply that will result from this balance sheet reduction.

After the 2007–2008 financial crisis, the Fed took on trillions of dollars in mortgage-backed securities, government bonds, and other assets to support the faltering economy through a process known as quantitative easing. The Fed hopes with the initial pace of unwinding at $10 billion a month—a small portion of their balance sheet—market impact will be subdued. However, this is the first time a central bank that adopted such a large bond-buying program has ever tried unwinding it.

Short-Term Interest Rates

While the Federal Reserve held rates steady in their September meeting, the consensus likelihood of a December rate hike increased to 80% following the hawkish tone in their statements and suggestions of economic viability.

The Fed has traditionally used inflation, wage growth, and employment to determine where to set interest rates.

Inflation

Inflation remains stubbornly below the Fed’s 2% target and its roughly 3% historical average. As the Fed has communicated its strong desire to raise interest rates in December and three more times in 2018, they need to move cautiously to avoid choking off economic growth and potentially inverting the yield curve. An inversion of the yield curve occurs when long-term debt securities have a lower yield than short-term debt securities of the same credit quality and is considered a predictor of a recession.

Wage Growth

Wage growth did increase to an average of 2.5% in the third quarter, reaching as high as 2.9% growth in September; however, the trend could be transitory, so it’s too early to tell if this could help create a more stable inflationary environment.

Unemployment

Meanwhile, unemployment was at 4.2% in the third quarter, below the traditional 4.6% full-employment benchmark. The US economy lost 33,000 jobs in September for the first monthly loss in seven years; however, this is mostly blamed on the recent hurricanes in Texas and Florida.

Long-Term Interest Rates

Despite the possible increase among short-term interest rates, the global demand for longer-term, US fixed-income investments remains very strong. As most developed nations’ populations are aging, investors seek safer, income-producing investments.

US government bonds currently offer higher yields than most foreign bonds and are viewed as having little credit risk. This immense demand is already causing the shape of the US Treasury yield curve to flatten as long-term yields are bought down while the Fed raises short-term interest rates.

Board of Governors of the Federal Reserve System

The biggest question surrounding interest rates, however, is who’s going to be the next Federal Reserve Chairperson. Current Chairwoman Janet Yellen’s term ends in February 2018 and President Trump is expected to name his nominee for the position in the upcoming weeks. There are also three vacant spots to be filled on the seven-member Federal Reserve Board of Governors.

The Federal Reserve’s outlook and direction could drastically change over the next year, depending on who fills the vacant seats.  

Looking Ahead

Global economic growth is expected to continue its steady acceleration and there are few imminent threats on the horizon for the rest of 2017; however, there are several important influencing factors that could have an effect on the market in 2018.

Potential Tax Reform

Equities in the United States continue to trade above their historical valuations. The market’s current overvaluation may be somewhat mitigated, however, if the White House administration’s proposed corporate tax cuts are passed by Congress and implemented.

Many entered the year expecting tax reform, or at least corporate tax cuts, in 2017. As time passes, the likelihood of tax reform occurring before the end of the fourth quarter continues to decline. The market has shrugged off the delay so far, and expectations for tax reform have shifted to the first quarter of 2018.

Municipal Bonds Demand

If the White House administration’s current tax reform proposal is passed and enacted by Congress, municipal bonds may also see some choppiness. If individual tax rates are lowered, the demand for municipal bonds will be affected.

Municipal bonds offer tax-free income. If investors have a lower tax burden, they’ll have less need for tax-exempt income. However, if state and local tax deductions are removed, as proposed, municipal bonds would be one of the few remaining tax breaks available—and that could increase demand.

As the tax reform proposal evolves, volatility in the municipal bond market may increase as investors digest potential implications of changes to tax policy.

The municipal bond market has also been experiencing decreasing supply and increasing demand for the past several years, meaning short-term volatility could create buying opportunities for long-term investors.

Populism

Nearly one-third of all major international elections have been won by unconventional, populist-platform candidates or policies since the end of February 2016, including the Brexit referendum, the US presidential election, and Italy’s constitutional referendum. More recently, populist parties have won seats in the German and Austrian parliaments.

This is a trend to watch closely, since nationalist views can impact global trade and growth.

Geopolitical Risk

While the market hasn’t reacted negatively yet, tensions rising on the Korean Peninsula, questions surrounding the Iran Deal, and US political gridlock all present possible risks to the market as investors may feel less confident in the future of the economy.

Chinese Congressional Elections

The 13th National Congress in China will be elected from October 2017 to February 2018 and will be in session from 2018 to 2023. Since China and the United States are the world’s two largest economies, the outcomes of these elections and the resulting policy changes could have a significant impact on global trade.

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To learn more about your portfolio’s areas of opportunity or the potential impact of global events, contact your Moss Adams advisor.